All the way from Manhattan, the New York City Opera performed the well-known opera ‘Carmen’ in a somewhat shortened format for the event’s attendees – I was surprised by the format as the opera was done with only just a piano (without the usual gigantic orchestra). However, the New York City Opera was no less brilliant, and marveled the crowd and performed superfluously!

Carmen tells a tale of the tragic downfall of a brave solder Don José and his encounter with a beautiful gypsy lady by the name of Carmen. Don José, seduced by the attractive charms of Carmen, gives up almost everything he has and chases her to show and declare his love. He even quits being a soldier and goes into a life of banditry to join Carmen and her gypsy life.

With a beautiful libretto, and a background score in the classical setting of late 19th century southern Spain, the opera is widely acclaimed and appreciated by many, and apparently holds several key lessons on human psychology and our behavioural biases.

According to hedge fund manager Roy Niederhoffer, who founded and runs R.G. Niederhoffer Capital Management, the tale from this beautiful opera exemplifies many lessons on behavioural finance that we as investors can learn from.

One example would be the narrative of Don José falling to the charms of the attractive Carmen and deciding to go after her (just like what we mere mortals tend to fall into as well). A prospective investment may have the same charms as Carmen – attractive potential returns coupled with dazzling prospects on the surface. We fall prey to our emotional biases the minute that taints our rational faculties in the decision-making process.

The well known sunk-cost fallacy was also seen in Act 3 when Don José pursued Carmen even more and joint her and her gypsy friends in a life of banditry when he felt he cannot lose her after sacrificing his loved ones and his career as a soldier (technically he could go back to his normal life). Niederhoffer pointed out that this very much describes the mistake of an investor doubling down on an initial bad investment in the hopes of recouping his losses should the investment recover in value.

Behavioural biases are thus real, and affect our decision making and thought processes from time-to-time. We therefore require a robust framework and method in order to deal with this human phenomena.

Legendary investor George Soros has also expressed the tendency for our behavioural biases to influence our actions in the financial markets and manifest themselves in the fluctuations in security prices, causing bubbles, manias and busts (I will talk about Soros in another post some time soon). In order to address this issue, the Palindrome adopts “Popperian Falsificationism” in his investment process during the days when he was actively managing money on Wall Street, which was a mode of thinking learnt from the philosopher Karl Popper.

Additionally, behavioural and emotional mistakes in the financial markets can be utilised as an opportunity to generate alpha. How so?

Value investors are known to scour for mispriced assets, buying cheaply-valued debt and equity securities and waiting for them to converge to their fair values. Often, many of these underpriced securities have resulted from overreaction in the markets (caused no doubt by irrational decision making by participants). Thus, disciplined value investors can have their lunch by capitalising on such opportunities.

R.G. Niederhoffer Capital Management also aims to generate uncorrelated returns from manifestations of irrational, short term behavioural biases of market participants, trading systematically across liquid bond, equity, currency and commodity markets. In fact, this well-known CTA firm capitalises on continued increases in emotional responses from both discretionary and systematic investment strategies with their “long volatility” exposure (making more as volatility rises).

It’s therefore no surprise when successful investors often say that 30% of successful investing is attributed to the skilled control of one’s own behavioural biases when participating in the markets. A book that I feel can be a good starting ground is James Montier’s “Little Book of Behavioral Investing” – check it out!